Cheapest Revenue Debt Draws Buyers Fleeing Stockton: Muni Credit

The worst-performing part of the municipal market is drawing buyers as bankrupt Stockton, California’s attempt to stick investors with a loss heightens the appeal of debt backed by revenue from services such as water and electricity.

A federal judge said this month that Stockton, the most-populous U.S. city to enter bankruptcy, can stay under court protection. Bondholders will probably get less than they’re owed, and that precedent makes debt paid through sewer or transport revenue attractive because those payments have stronger legal protection than general obligations, said John Mousseau, a portfolio manager at Cumberland Advisors in Vineland, New Jersey.

Water and sewer debt has earned 0.7 percent this year, the lowest among 10 revenue-bond groups, compared with 1 percent for the broader $3.7 trillion muni market, Barclays Plc indexes show. Yet Cumberland, which manages about $2.2 billion in debt, joins Morgan Stanley analysts in favoring such bonds.

The revenue “goes from the farebox to you,” said Mousseau, who has bought securities from the Los Angeles Department of Water & Power and Chicago’s O’Hare International Airport this year. “You’re more secure that way.”

Choices Ahead

Investors have their pick of such deals this month, including a $242 million offer from Portland Water System in Oregon, a deal from Richmond Public Utility in Virginia and an issue from the Los Angeles water agency.

With a growing economy fueling bets that interest rates are set to rise, Morgan Stanley has essential-service revenue debt pegged as its favorite muni segment this quarter. Such securities “tend to do better” in that context, Morgan Stanley analysts led by Michael Zezas wrote in note this month.

Ten-year Treasury yields will climb about 0.5 percentage point to 2.25 percent by year-end, according to the median forecast of 66 analysts in a Bloomberg survey.

Morgan Stanley likes most types of revenue borrowings because they provide “extra yield and a more stable near-term credit trajectory,” Zezas said in an e-mail. The segment has “the added benefit of downside protection against broader bankruptcy stress.”

Stockton Rarity

Before filing for bankruptcy in June amid mounting retiree health-care costs and an eroding tax base, Stockton asked investors to take less than what they’re owed on pension and lease-revenue bonds backed by the city’s general fund.

The demand would’ve left investors with the equivalent of 17 percent of future payments in the case of pension debt, Moody’s Investors Service said.

The city of 296,000 east of San Francisco is a rare case. From 1980 to 2013, 274 Chapter 9 filings occurred, of which 52 were by a city, village or county, according to James Spiotto, a partner with law firm Chapman & Cutler LLP in Chicago.

Yet Stockton was one of three California municipalities filing for court protection last year.

Robert Miller, who helps oversee $32 billion of munis at Wells Capital Management, said he’s avoiding similar debt from California issuers that is paid from the general fund and doesn’t carry an unlimited tax pledge.

Contract Comfort

“The market is recognizing there is increased risk associated with these structures,” he said from Menomonee Falls, Wisconsin. “And as a result, they’re going to require higher levels of yields.”

The “defined revenue stream” from essential services is an “argument that you have a contract that can’t be set aside necessarily by bankruptcy court,” he said.

He bought debt this year from the Cucamonga Valley Water District, a system serving parts of San Bernardino County, California. Miller said he got as much as 0.20 percentage point of extra yield compared with general-obligation bonds of the same rating.

He bypasses debt from the city of Detroit while picking up bonds from its water and sewer system. He said the facility’s revenue is separate from that of the city, which in March was put under a state-appointed emergency manager as it tries to avert bankruptcy.

Distress Distance

Some portfolio managers avoid revenue bonds from entities associated with fiscal distress. Jamie Iselin, who helps oversee $11 billion as head of munis at New York-based Neuberger Berman Group LLC, says the payoff isn’t worth the volatility.

“If you’re holding Stockton water and sewer debt through this whole process, you feel better than if you own Stockton pension bonds,” Iselin said. “But it has not been a ride without a lot of bumps, liquidity give-up and wider spreads.”

No city or county since at least the 1930s has used the power of a U.S. bankruptcy court to force a reduction in debt principal.

Creditors including Assured Guaranty Corp. and Franklin Resources Inc. say Stockton is seeking to cut debt while still maintaining millions of dollars in future payments to the California Public Employees’ Retirement System.

An outcome that causes pensioners to take a hit would make municipal bankruptcy “that much more attractive an option for cities and local governments, and not just in California,” Matt Fabian, managing director of Concord, Massachusetts-based Municipal Market Advisors, wrote in an April 8 research note.

Busiest Span

Amid the busiest stretch of issuance since June, yields on tax-exempt debt are eclipsing those on Treasuries to start this week.

Ten-year benchmark muni yields at 1.77 percent compare with 1.72 percent on similar-maturity Treasuries. The muni interest rate has been below its federal counterpart on only day in the past month.

Issuers are offering almost $22 billion between last week and this week.

New Jersey plans to sell $350 million of general-obligation bonds as soon as next week, data compiled by Bloomberg show. It would be the state’s first new-money, general-obligation deal since 2009, according to the state’s 2012 debt report.

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